Protection from unexpected moves

Stocks tumbled on July 31, 2014 with the Dow and S&P 500 posting their first monthly drop since January ‘14 as investors worried about Europe's economy, an Argentine default and a jump in U.S. labor costs prompted concerns about corporate margins.

Many traders who didn’t guess that these corrections were coming in these markets continued to stay in the markets waiting for a correction and then got stopped out and made no profit, or even lost money.

This can be true of options on futures and equities. You can create an options strategy where your risk is specifically defined, but this usually involves multiple legs and can get complicated, not to mention expensive. If you are not precise, you can end up with “hidden” risk.

The price of binary options provides a picture of how the market (traders) views how a particular event will affect market direction during a specific period.

The relative cost of a binary option is a matter of whether you are taking a position that has a relatively high probability of occurring or a relatively low probability of occurring. We say relative because your opinion of the likelihood of an event occurring can be different than the market at any given time. In fact, that is precisely what makes a market.

If an event has no bias, that binary option would be priced somewhere around 50, meaning the odds of it occurring or not occurring—as priced by the market—are equal. If you are taking a position on an event with a high likelihood of occurring you will be risking more—the price would be 60-70-80, etc., depending on time and price.

If you are taking a position on a potential outcome with a low probability the cost of the binary would be low. Some people in traditional options trading call this a homerun trade—a trade that most likely would be a loser, but has a low cost and in the unlikely event you are correct, would pay off well.

This can be a way to take a low risk flyer on a market crash or used as a risk management procedure. You may have a long equity position that is meant as a long-term investment and aren’t particularly concerned with a minor drawdown. However, with the risk of a sharp reversal you may buy some way out-of-the-money puts in case of a more serious move. This would cost you little and offset a sharp reversal in the index.

Recently there has been a lot of technical/cycle work on the S&P 500 suggesting a serious correction is due. If you saw this as a strong possibility you could have used binaries over the past few weeks if you thought the E-mini S&P 500 would have a sharp downward move. The E-minis settled at 1971.50 on July 28. Aug. 1 that market settled at 1918.50. Binaries predicting that E-mini would settle at below 1940, 1930 or 1920 were relatively cheap. They could have been bought as a long shot or as a way to hedge an existing position.

On Monday, July 28, Nadex was listing US 500 (based on the E-mini S&P 500 futures) strike prices of 1921.5 and 1933.5 that expired on Friday, August 1 at 4:15 PM EST. If a trader was looking to protect against, or speculate on a large downward move, they would have sold the binary. On Monday, the 1933.5 strike could have been sold for $90.50 per contract. At that level, the traders’ maximum risk would be $9.50 per contract and that would be the collateral required to place the trade. The 1921.5 strike on Monday could have been sold for $93.00--meaning $7.00 maximum risk per contract to the trader with $7.00 collateral required to place the trade.

On Friday, both of these contracts settled at 0, so if sold at the previously mentioned levels on Monday, the 1921.5 would have produced $93.00 in profit per contract and the 1933.5 would have produced $90.50 profit per contract. These figures are not inclusive of exchange fees.

In the coming weeks we will continue to capture timely examples of how you can be a better trader using binary options.

*Past performance is not necessarily indicative of future results. Futures, options, and swaps trading involves risk and may not be appropriate for all investors.